AT long last it has come, the day of reckoning for the American economy. That’s what some experts are saying as they study the data that have been published since Hurricane Katrina struck the oil, gas and shipping industries. True, the figures contain more good news than bad. It is now clear that the economy was growing at a rapid clip before the storm, with activity high and the jobs market strengthening, and that Katrina did not derail the economy.
But the inflation hawks have been circling for some time, and the good news has given them reason to pounce. The Federal Reserve’s latest survey of business conditions notes that “activity continued to expand in September . . . retail sales of general merchandise increased in most (Federal Reserve) Districts . . . employment has been rising . . . service activity expanded in almost all the Districts that reported on this sector . . . manufacturing activity rose in all Federal Reserve Districts except St Louis . . . all the Districts reporting on commercial real- estate conditions noted rising demand for office, retail or industrial space.”
There were, to be sure, a few caveats scattered throughout the report (car sales were slow, the rise in retail sales was “moderate”), but its general tone can only be characterised as cheery. But it did not look that way to the hawks, who focused on the fact that the Fed survey noted “a pick-up in cost pressures . . . a general escalation of costs for manufacturing inputs”. These rises in costs would not result in higher prices if companies were forced to absorb them. But boardroom talk, mere whispers at the moment, is of the return of “pricing power”, the ability to pass on these cost increases to consumers.
The hawks have already noted that in September soaring energy prices caused a 1.2% increase in consumer prices, the largest jump in 15 years. In the past, such energy-led increases have been dismissed as mere volatility, likely to be reversed. But it would be imprudent in the extreme to base monetary policy on the assumption that oil and natural-gas prices have merely peaked, rather than reached some new plateau.
Add to the mix of data that is fuelling the concern of the inflation hawks the inability of Congress and the unwillingness of President George Bush to control spending. Republicans want to cut food-stamp and healthcare aid for the poor, while Democrats want to raise taxes on the “rich”. The result, at least so far, is a stalemate: the spending goes on and the deficits continue.
All of which means that there is almost no chance that the Fed will reverse its policy of steady, quarter-point rises in interest rates so long as Alan Greenspan is its chairman. This means that Greenspan will step down with the fed funds rate at 4.5%. His successor is unlikely to upset markets by calling a sudden halt to the rate increases at his first meeting, or even his second.
Indeed, if that successor turns out to be Donald Kohn, who has been with the Fed for more than three decades, first as a staffer and more recently as a governor, the inflation hawks will have control of the nest. Washington insiders say Greenspan has urged the president to name Kohn as the next chairman of the Federal Reserve.
Kohn took the opportunity provided by a conference in Pittsburgh to note that “the risks may be skewed a little toward the upside on inflation. Because . . . activity is most likely on a solid upward track, my focus at this time is naturally on keeping inflation contained . . . We are not yet at a point where we can stop” raising rates.
Add all that up and you get a fed funds rate of 5% by May 2006.
That, most experts agree, will drive long-term rates up, cool the housing market and the “mortgaging out” (profiting from the rise in house prices by withdrawing equity) that has financed as much as 40% of the growth in consumer spending last year, force people to take notice of the increase in the debt charges on their variable-rate mortgages and credit- card balances, and almost certainly prevent the economy from continuing to grow at anything like the 3.5%-4% rate that it has been chalking up.
Some think the Fed will have overshot, as it has in the past, and thereby produce a recession. Others disagree, and see growth slowing to an annual rate of about 2%.
If either the overshooters or the two-percenters are right, 2006 will be the year of the beginning of a correction to the imbalances that are worrying so many policymakers. American consumers will spend less, reducing their outlays not only on made-in-America products but also on imports. That should start to whittle down the trade deficit, now running at about 6% of gross domestic product, a level that is thought to be unsustainable. A reduction in imports inevitably means that China’s exports will drop, and with it China’s growth rate. Result: an easing of demand pressures on international oil and commodities markets.
All this seems to be adding up to a slightly painful adjustment, though not an unwelcome one if it does not become too severe or too protracted, which it won’t if Kohn is right that the deceleration in consumer spending will be partly offset by growth in business spending on capital equipment.
To say that this scenario should be taken with a large dose of uncertainty is to put it mildly. Too many things are happening that economists cannot explain. The US trade deficit mounts, but the dollar fails to collapse. A survey by Merrill Lynch shows that “American equities are the most unpopular investment class in the world”, but net capital inflows are rising as US residents sell off their holdings of foreign-issued securities. The Fed keeps raising short-term rates, but longer-term rates refuse to rise proportionately, creating the “conundrum” that has Greenspan so puzzled.
All of which should make life interesting for Kohn or whoever ends up in Greenspan’s chair just 100 days from now.
Irwin Stelzer is a business adviser and director of economic policy studies at the Hudson Institute
